The attorneys general of New York and Connecticut have subpoenaed several banks accused of manipulating LIBOR, the now-infamous London Inter-Bank Offered Rate that is a key indicator of short-term interest rates. The attorneys general hope to identify and perhaps recover billions in taxpayer dollars that may have been lost on financial instruments governments use that are tied to LIBOR. Other state and local governments are almost certain to follow.
The LIBOR scandal should remind us once again that people — namely investment bankers, traders and brokers — sometimes make bad decisions when their principal objective is to produce immediate profits. It should also help us realize that we often put our governments' chief finance officers, treasurers, budget directors and other financial leaders in an equally tenuous position.
Trillions of dollars in financial assets around the world are determined by investment bankers' perceptions of where the market is headed. LIBOR is a key measure of those perceptions, and we have every right to know if those same bankers rigged that measure at the expense of other investors. At the same time, it's puzzling to see policymakers and citizens so shocked to learn that a few bankers in London could affect government balance sheets in the United States so dramatically. The LIBOR scandal is principally about greed, but it also has helped to show just how much events we do not control — what accountants call "contingent liabilities" — are a part of public finance today.
Contingencies are nothing new in public finance. What is new is how we deal with them. In the past, we used "counter-cyclical" tools and, when necessary, budget policy. For instance, a rainy-day fund could cover a revenue shortfall if the economy grew at 3 percent even though the revenue forecast had assumed 4 percent. But far more important, if the rainy-day fund was not large enough, policymakers and taxpayers alike could agree to raise taxes or cut services as necessary.
Today, financial risk management can do some of that heavy political lifting. One-time budget and accounting gimmicks — recall when New York State "sold" Attica Prison, or the "13th month" of sales-tax collections in many states — are as old as budgets themselves. But the long-term implications of those gimmicks had little to do with the tumult of financial markets. Now, when market conditions are ripe, a state or municipality might close a budget gap by lowering its debt-service costs with an interest-rate swap or some other financial instrument. But what if market conditions are only sort of ripe? If elected officials are willing to take the additional financial risk, there's a financial instrument to facilitate that additional risk-taking. And most public organizations have finance professionals who can make just about any financial instrument, no matter how imprudent, look good on paper. As we saw with Jefferson County, Ala., and many other jurisdictions, when the market behaves in unexpected ways those instruments can backfire. And when they do, citizens bear the brunt.
In that sense, the environment we are creating for our public-finance leaders is not that different from the environment that led to the LIBOR scandal. In the political pressure cooker of a budget process that demands the same results with fewer and fewer resources, it's natural to want to downplay the bad contingencies and celebrate the good ones. If we keep using financial risk-management tools to solve political problems, we force our public financial leaders into the unenviable role of asking tough "what if" questions. Many of them are up to the task, but that's a lot to ask of anyone.
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